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The Perils Of Overconfidence

Tyler Durden's picture




 

By John Goltermann, CFA, CPA, Obermeyer Asset Management

August 2012: The Perils of Overconfidence

Howard Marks, who runs Oaktree Capital (a very successful hedge fund that principally invests in distressed securities), recently pointed out that

mistakes are all that superior investing is about. In short, in order for one side of a transaction to turn out to be a major success, the other side has to have been a big mistake…Usually a buyer buys an asset because he thinks it’s worth more than the price he’s paying. But the seller sells the asset because he thinks the price he’s getting exceeds its value. It’s pretty safe to say one of them has to be wrong. Strictly speaking, that doesn’t have to be true, thanks to differences in things like tax status, timeframe and investors’ circumstances. But in general, win/win transactions are much less common than win/lose transactions. When the dust has settled after most trades, the buyer and seller are unlikely to be equally happy.

We all make mistakes. In the investment world, some mistakes arise from having imperfect information, some from not anticipating the future correctly and some from sloppy analytics. Sloppy analytics includes everything from outright mathematical errors or misinterpretations, to poor assumptions, to overfocusing on unimportant variables or underfocusing on important ones. Analytics is the most critical and controllable part of the investment process, but even if done flawlessly does not ensure a favorable outcome by any means because the views/ behaviors/incentives of other investors – and indeed, the investment environment itself – change continually in ways that can’t be anticipated.

But there is one more common mistake that is a consistent source of perplexity for active investors. Over the years, my experience has been that those who lose money more often (and in greater amounts) than they should, often do so because of overconfidence. Overconfidence can lead to the conviction that one is only buying investments that will be highly profitable and one is only selling investments that no longer have significant upside potential. This can lead to a lack of diversification and a heavy concentration of money in a single investment or asset class.

Overconfidence, however, also leads to overtrading. Trading volumes frequently increase because investors believe that they can precisely time market entry or exit points, either by themselves or with the assistance of complex trading models or charting software (there is an entire industry that capitalizes on this belief by peddling software, seminars, programs, subscriptions and other money-making schemes). So what we have at all times is a Lake Wobegon situation in investment markets, “where all the women are strong, all the men are good looking and all the children are above average.” This makes for high drama at the times when beliefs conflict with reality.

The above chart highlights the rampant and systematic short-termism in investment markets. This trend makes it very difficult (likely impossible) to be consistently correct in establishing positions because of the fickleness of other investors – investors who often ignore the values and long-term economics and risks of the businesses in which they invest. The good news (for patient investors) is that this also means that mispricings occur. We saw high levels of trading in housing when it was near its speculative top, we saw high levels of trading in tech stocks when they were near their speculative top and now we see high levels of trading in the stock market generally.

I am not suggesting that the stock market is near a speculative top because many other factors serve to increase trading volumes through time (making trades is now almost costless, technology makes it easy, the number of tradable issues has increased and the Fed encourages speculation through loose monetary policy); but within the market itself, individual issues’ trading volume can indicate the level of speculative activity around an investment (and what may be more vulnerable to disappoint).

While speculating and trying to predict future investor behavior is fine (and there are managers who do it well), it’s always well-advised to hold investments that have economics in their favor and that are priced for potential upside (their businesses’ value is greater than the market value of their stock price plus their debt). In the process of making such investments, it is inadvisable to pay much attention to the pronouncements and prognostications of Wall Street  promoters and others with a vested interest in ridding themselves of future poor investments by promoting them to an unsuspecting public. Price relative to value is everything for those with an investment horizon of more than a year.

It is surprising that many investors have to re-learn (the hard way) that the ebullience emanating from Wall Street firms on the latest and greatest trend, business model, gadget or idea is frequently wealth-destroying. We can see this in post-IPO share prices of Facebook (FB) and Groupon (GRPN), two companies with IPOs that attracted much hype and hyperbole (and that engendered so much confidence):

Retail investors, in effect, are the group most often targeted to take up investments that the private equity firms, underwriters and their hedge fund clients don’t want. Private equity firms, which have nurtured these companies along from inception and groomed them for the day they can go public, salivate for their IPO post-lockup payday so that they can redeploy their capital in the next hot deal and pay out their partners. But rest assured, when shares are finally offered to the public, they are not offered at rock-bottom prices and the financials have been carefully finessed to put the best face on the investment. Consider the incentives: if you were the owner of a perfectly good investment that was being underpriced by markets, why sell it in the first place?! Whenever you find Wally Street cheerleaders and promoters whipping individual investors into a frenzy (especially over IPOs), put one hand over your wallet.

In the month of August, the market remained within a tight trading range. Material stocks are now priced at depressed levels while dividend stocks have become the darlings of institutional investors. Selling economically sensitive stocks and buying dividend stocks has been the trade that has been “working.” I am not saying that materials stocks cannot move lower, but rather that the good ones are likely trading well below their economic worth and prices do not reflect the potential of their long term cash-generating ability. Many (though not all) dividend payers look expensive relative to the cash-generating ability of their businesses, so those who advocate this strategy or invest this way must be prudent. I have never felt comfortable with making investments based on the characteristics of the security itself instead of the price/value relationship of the underlying asset(s) and the economics of the business that the stock or bond finances.

We put very little effort into prognosticating where “the market” itself is going. As Erik Kraus recently observed in his June newsletter, “The market currently offers a truly extraordinary opportunity! There is only one problem – We have absolutely no idea whether it is a buying or selling opportunity.” Similarly, we have no strong conviction about the market’s future direction one way or the other – but there are lots of people who do!

As with any other prognostication, it’s best to regard market calls with a healthy degree of skepticism. As Bertrand Russell said, “The whole problem with the world is that fools and fanatics are always so certain of themselves, and wiser people so full of doubts.” We try to have the right kinds of doubts when evaluating investments, and seek to own those that others aren’t overly enthusiastic about but that have favorable economics and are priced with a margin of safety. We feel that this approach, in combination with an appropriate asset allocation for each client, makes an accurate forecast of the near-term direction of “the market” unimportant.

 

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Fri, 08/17/2012 - 11:22 | 2714192 LoneStarHog
LoneStarHog's picture

"We all make mistakes" ????? Apparently you have not read such investment boards as Yahoo! Locally, you have not followed RobotTrader nor MillionDollarBonus.

Fri, 08/17/2012 - 11:23 | 2714201 SilverTree
SilverTree's picture

Premature ejaculation. 

Fri, 08/17/2012 - 11:32 | 2714216 Precious
Precious's picture

"When the dust has settled after most trades, the buyer and seller are unlikely to be equally happy."

Knight would agree with that.

Fri, 08/17/2012 - 13:02 | 2714565 falak pema
falak pema's picture

massive HFT !

Fri, 08/17/2012 - 11:27 | 2714211 Snidley Whipsnae
Snidley Whipsnae's picture

Nor have they read the bard... "to err is human, to forgive is ______"

Fill in the blank to suit yourself.

Fri, 08/17/2012 - 11:58 | 2714278 NotApplicable
NotApplicable's picture

A sign of weakness?

Fri, 08/17/2012 - 13:01 | 2714561 falak pema
falak pema's picture

pass me de vine! 

Fri, 08/17/2012 - 23:31 | 2716072 Yen Cross
Yen Cross's picture

 We certainly do!    We can dwell on our mis-forgivings, or share our mistakes! Fantastic post " Lone Star"

   It's a good thing to give back! +1

Fri, 08/17/2012 - 11:22 | 2714194 time2blowitup
time2blowitup's picture

You know it's a slow day when you're eagerly awaiting the imminent FB $18 handle post!! Any second now.....

Fri, 08/17/2012 - 11:25 | 2714206 LoneStarHog
LoneStarHog's picture

Praise Da Lord & Pass The Shares! ... Another great buying opportunity ... Someone (nameless) will have millions of shares for each of his/her grandkids.....

Fri, 08/17/2012 - 11:23 | 2714196 Dalago
Dalago's picture

Unless you're Goldman Sachs.  Then you just control that shit and are on BOTH side of the trade.  Just fuck the world, would ya?  Don't mind if I do.

Fri, 08/17/2012 - 11:25 | 2714203 Snidley Whipsnae
Snidley Whipsnae's picture

OT: but interesting...

"Geitner Foaming the Runway for the Banks" Barofsky: Where Did the Bailout Money Really Go

http://maxkeiser.com/2012/08/17/foaming-the-runway-for-the-banks/

Fri, 08/17/2012 - 12:59 | 2714553 falak pema
falak pema's picture

wonder who is foaming the runway in Damascus and maybe in Tel Aviv; long hot summer! 

Fri, 08/17/2012 - 11:26 | 2714210 fonzannoon
fonzannoon's picture

Another artcile trying to rationally evaluate the market...lol

Fri, 08/17/2012 - 23:48 | 2716082 Yen Cross
Yen Cross's picture

 There isn't much I can say? Thanks for your input! You and Slewie are Geniuses!

  Slewie is brillant,

Fri, 08/17/2012 - 11:35 | 2714223 Seize Mars
Seize Mars's picture

The win/lose mentality is pervasive. It's amazing how many people have grown up with this idea. It's no wonder that they teach Red bullshit to morons at University - it seems sensible when you listen to this "win/lose" thing all day long.

Real freedom, that is, transactions that are in no way coerced, and voluntary on both sides, are absolutely win/win, every time. If someone is being coerced, then there is a guaranteed loser. If trade is truly volutary, then everyone is better off with the trade. Everyone wins.

Yes, kids, it's true, and it's the "shabby secret" that the scumbags don't want you to learn about: business makes everyone better off. Everyone. There is no reason for anyone to be a loser.

The key is that it must be coercion-free.

Fri, 08/17/2012 - 11:41 | 2714235 Tinky
Tinky's picture

I'm afraid that is a bit too simplistic.

Were investors "coerced" to have their money managed by Madoff, Corzine, etc.?

For business to make "everyone better off", there is much more required than a lack of coercion.

Fri, 08/17/2012 - 12:03 | 2714300 NotApplicable
NotApplicable's picture

It's deeper than that. The coercion occurs behind the scenes relying upon a facade of integrity to conceal it. Corzine, for instance, should most likely be in jail, yet he will never even be charged, due to the coercion that protects him.

Fri, 08/17/2012 - 12:18 | 2714357 FreedomGuy
FreedomGuy's picture

I agree. The model presented in the article is actually more a gambling model. You bet on red and it goes to black. The casino wins and you lose or vice versa. In trading I might sell a stock that has appreciated sufficiently and buy something with a better dividend but less appreciation. Both people can win on both sides of the trade. I may sell a perfectly good stock at a fair market price to buy a bond with a fixed yield as I approach retirement. Again, everyone can be happy.

The real problem is that almost every market is now government manipulated. The Fed and EU central banks artificially price bonds and keep money cheap when it should be very expensive. The sends false signals to move money to other areas so perhaps stocks get overprices for lack of bond yields. That is why a statement from Merkel, Draghi or Bernanke can completely overwhelm any analytics you might do. They can roll the markets up or down with two or three sentences.

On the micro side, yeah, analyze Facebook and don't fall for the hype, but the broader markets are all gambles these days. So, the analogy to gambling with winners and losers is probably MORE appropriate now than it used to be or it should be.

Fri, 08/17/2012 - 12:34 | 2714435 BigJim
BigJim's picture

You're missing the point. He's not discussing voluntary vs involuntary transactions; he's discussing the trading of securities that change in price, which by definition means the price will go for and against the prognostications of the two parties involved.

If the price rises substantially after the seller sells, he has lost money (barring the circumstances the author explicitly outlined), and if it drops, the buyer has lost money.

What you're failing to see is that gambling - which is what the vast majority of trading boils down to - is by definition a win/lose proposition... and, given market-maker's commisions, on average, is a lose/lose proposition.

The fact that both parties voluntarily took part is irrelevant. He's not making an argument against free-markets.

Try reading it again.

Fri, 08/17/2012 - 11:41 | 2714236 Debtonation
Debtonation's picture

I still own the same gold and silver I bought 7 years ago.

Fri, 08/17/2012 - 18:26 | 2715603 EclecticParrot
EclecticParrot's picture

Unfortunately, after cleaning out my cupboards today, I can say the same thing about a box of Kashi bars . . .

Fri, 08/17/2012 - 13:39 | 2714708 Venerability
Venerability's picture

Where is the overconfidence you are seeing, Tyler?

Pretty much every commentator around is now an Uber-Bear, sobbing heavily into his beer and/or champagne.

The only real exuberance anywhere in the markets these days is still coming from the Euroshorts - and there are still way too many of them.

 

Fri, 08/17/2012 - 23:37 | 2716076 Yen Cross
Yen Cross's picture

 As you sob in your " Buttery Zin"? under the soft glow of " Rosemary Petals"?

Fri, 08/17/2012 - 16:30 | 2715272 _ConanTheLibert...
_ConanTheLibertarian_'s picture

- Assumption is the mother of all fuckups -

Fri, 08/17/2012 - 23:38 | 2716077 Yen Cross
Yen Cross's picture

 That quote was saved.

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